IRS Issues Final Employee Stock Purchase Plan Regulations

On Nov. 16, 2009, the Internal Revenue Service and U.S. Treasury Department issued
final regulations governing Employee Stock Purchase Plans (ESPPs) under Code Section 423. Many companies recognize ESPPs as a low-cost opportunity to provide employees with incentive compensation, on a tax-favored basis, by selling them company stock at a slight discount.

The final regulations made no dramatic changes from proposed regulations issued in July 2008. However, the final regulations do make a few important clarifications (and reject one widely sought change). The following key issues bear special mention:

Determining the Grant Date

Determining the "grant date" of an ESPP "option" is critical for tax reasons. The one-year and two-year holding periods required to receive favorable tax treatment of ESPP shares begin on the "grant date." Ideally, this should be the first day of the offering period, rather than the last day. The regulations provide that the grant date will be the first day of an offering period if the terms of the ESPP or offering designates a maximum number of shares that may be purchased by each employee during the offering or requires the application of a formula to establish, on the first day of the offering, the maximum number of shares that may be purchased by each employee during the offering.

The regulations do not require that an ESPP or offering designate a maximum number of shares that may be purchased by each employee during the offering or incorporate a formula to establish a maximum number of shares that may be purchased by each employee during the offering. If the maximum number of shares that can be purchased under an option is not fixed or determinable until the date the option is exercised, then the grant date will be the purchase date.

The regulations clarify that specifying the $25,000 limit under and the overall limit on the number of shares that may be issued under the ESPP is not sufficient to establish the maximum number of shares that can be purchased by an employee so that the grant date will be the first day of the offering. Under this circumstance, the grant date would be the date the shares are purchased at the end of the offering period.

Application of the $25,000 Limitation

The regulations re-emphasize that an ESPP must provide explicitly that no employee may be permitted to accrue the right to purchase stock under all ESPPs of his or her employer (and related corporations) at a rate that exceeds $25,000 in fair market value of the stock (determined on the grant date) for each calendar year in which an option granted to the employee is outstanding. However, the regulations modify the proposed regulations to provide that the limit increases by $25,000 for each calendar year that an option is outstanding.

Coverage of Non-U.S. Employees

The final regulations set forth the categories of employees that may be excluded from coverage under an ESPP or an offering under the ESPP. The regulations permit multiple offerings under an ESPP
with different exclusions applicable to the one or more corporations whose employees participate in the particular offering. Thus, an employer has the ability to make future and overlapping offerings that are more (or less) inclusive than prior offerings under the ESPP.

Under the regulations, whether the terms of an ESPP and offering satisfy the coverage requirements of Section 423 and the regulations is determined on an offering-by-offering basis. The terms of each offering under an ESPP may be different, provided that the ESPP and offering together satisfy the requirements of Section 423 and the regulations. The terms of each offering may provide different exclusions of employees, but the exclusions established with respect to a particular offering must be applied in an identical manner to all employees of every corporation whose employees are granted options under that particular offering.

Unfortunately, the regulations do not permit employers to exclude from participation employees who are nonresident aliens and who receive no earned income that constitutes income from sources within the U.S. or under a specified age.

The preamble to the regulations provides, apologetically:

"The IRS and the Treasury Department are aware of the complexities often associated with participation in an employee stock purchase plan by nonresident aliens and employees under a specified age, such as the age of majority. However, section 423 does not provide exclusions for nonresident aliens or employees under a specified age."

However, the regulations clarify that an ESPP or plan offering, in order to comply with the laws of a foreign jurisdiction, may grant an option to citizens or residents of a foreign jurisdiction (without regard to whether they are also citizens of the U.S. or resident aliens) with terms that are less favorable than the terms of options granted under the same ESPP or offering to employees resident in the U.S.

Shareholder Approval

The regulations clarify that new stockholder approval is required if there is a change in the shares with respect to which ESPP options are issued or the granting corporation.

In particular, the regulations clarify that the stockholders of a subsidiary corporation include the parent corporation and any other stockholders of the subsidiary.

The regulations do not require the stockholders of an acquiring company to approve an amendment of the ESPP of an acquired corporate subsidiary in order to issue parent stock instead of subsidiary stock. Instead, the regulations require the acquiring company (rather than its stockholders) to approve the amendment of the ESPP to issue parent stock instead of subsidiary stock.

Effective Dates

The final regulations apply as of Jan. 1, 2010, and will apply to any ESPP option granted on or after that date. Employers may rely on these final regulations for the treatment of any statutory option granted prior to Jan. 1, 2010.

Michael S. Melbinger is a partner at Winston & Strawn LLP and is head of the firm’s Executive Compensation and Employee Benefits Department.